The Excess Liquidity Party is Over     

• The excess liquidity party of 2009 is over. From 2010, financial markets will have to transition from being driven by excess liquidity to economic and corporate profit fundamentals. So far, this transition is bumpy, and could get bumpier.
• China first spooked investors by moving to reign in soaring loan growth and rapid capital formation that offset the deficit in exports in 2009. The ECB ignored warnings from the IMF about moving too early to remove liquidity support, and is now having to deal with a sovereign debt crisis. The Fed is also scheduled to cease its MBS purchases in March.
• Whether the current interim correction is short and deep or shallow and long depends on how bond markets behave. The ECB’s actions have already slam-dunked the Euro and ignited a USD rally, while surging Euro sovereign debt yields could feed over into US mortgage and agency yields, as well as JGB yields.
• The resurgence in the S&P VIX volatility index indicates a lurch back toward risk aversion and cash. The cash will most likely come from emerging markets and commodities where the biggest gains are, meaning more short-term downside risk for both. The other indicator of a sudden dash for cash is the selloff in gold and a renewed upward surge in JPY. As a result, virtually all risk-trade markets are on the cusp of breaking down through 200-day MA support.
• Renewed risk aversion and JPY strength are not what Japanese equities need at this point. The fact that the Hatoyama Administration and the BOJ are singing off different song sheets regarding how to eradicate Japan’s deflation only compounds the downside risk.
• However, as Japan was a significant late-comer to the excess liquidity party and is demonstrably cheaper than global market peers, there is less downside risk, although the export sector is just as susceptible to profit taking as other global equity markets. While it could take several months or even up to a year for equity markets to transition from excess liquidity to fundamentals, we still expect a return to the underlying trends, i.e., a cyclical recovery in Japan and secular growth in the BRICs/emerging markets, and a recovery in global trade that will support commodities and basic materials. 
  

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